Small investors making smaller impact

Sunday

Before you sell all your earthly belongings and bet your life’s savings on a market rally, consider that small investors have had it right for the most part in recent years.

Small investors get no respect.

When they’re leaving the market, it usually means the market is heading up. When they’re investing in the market, it usually means the market is heading down.

Some professionals even use the actions of small investors as an indicator of the market’s direction. To make money in the market, do the opposite of what the small investor does.

As evidence, consider the stampede from the stock market that took place in early 2009. Many investors stuck it out through major losses in 2008 and finally, unable to take any more financial pain, they exited the market - just before the historic rebound that began in March 2009.

They’ve been tentative about getting back into the market and seemed to be gaining renewed faith in the market again until May, when the "flash crash" spooked them all over again.

So does that make this an ideal time to invest in the market?
Before you sell all your earthly belongings and bet your life’s savings on a market rally, consider that small investors have had it right for the most part in recent years.

Investors withdrew more money from equity mutual funds than they put in during 2002, 2007, 2008 and 2009, with that three-year period marketing the first time withdrawals exceeded investments since 1979-1981, according to the Investment Company Institute (ICI).

This year, inflows beat withdrawals in January, March and April, but withdrawals exceeded inflows in May. Again, small investors have not been far off.

Small investors have jumped into bonds and other investments, and have kept much of their savings in cash. But how have they fared compared with consistent stock investors?

"The S&P 500 stock index has fallen at an annualized rate of 3 percent a year over the past 10 years, including dividends and controlling for inflation," states The Wall Street Journal. "Long-term Treasury bonds show a gain of 5 percent a year during that same period, after inflation. Gold is up 10 percent a year and real-estate investment trusts 8 percent a year."

Other factors
The market exit by small investors is driven not only by fear and poor performance, but by need. Dollars invested in stocks increasingly have been needed to pay off debt.

Why invest in an uncertain market when your funds could instead be used to pay off credit card debt? Given the impact on credit scores and high interest rates, paying off debt is often the wiser use of limited funds.

Unemployment fears and the aging of baby boomers are also having an impact on investment behavior, according to Dr. Joe Duarte’s Market IQ.

In addition, data from the ICI shows a drop in risk tolerance among young investors. In 2009, just 30 percent said they were willing to take above-average risk in the stock market, down from 37 percent in 2008. The number willing to take below-average risk or no risk at all rose to 20 percent from 14 percent.

What it means
So what does it all mean? For one thing, it signals a significant change in the role of the small investor.

In the 1990s, as small investors jumped into the market in force, they increased demand and pushed stock prices up. Now, as investors flee the market, their exit is becoming self-fulfilling to some degree, as the exit by a large number of investors has held down stock prices.

The market void is being filled to some degree by high-frequency trading (HFT), in which computer-driven trading by large firms attempts to take advantage of momentary pricing inefficiencies. With HFT, highly leveraged trades take place in nanoseconds.

HFT, which played a role in the "flash crash," now accounts for a majority of equity trades. TABB Group, which researches financial markets, found that HFT accounts for 73 percent of all equity trading, up from 30 percent four years ago.

With small investors leaving the market, the dominance of HFT will increase.

The down side is that as investors leave the market, pricing is less reflective of demand. Pricing historically has been driven by the principle of supply and demand. A stock performs well when its fundamentals demonstrate great potential for investors.

Early predictions are that profit reports will be very favorable this quarter. As companies post their quarterly profits, it will be interesting to see how the market reacts.
It’s difficult to tell just how the market will react.

HFT could, in fact, contribute to wider price swings than if prices were affected solely by investor sentiment. As such, short-term, we believe it is wise to keep stock investments in place, as investors who sell now could miss out on a major opportunity.

Long-term, though, many factors are working against the market, including the potential of a double-dip recession and the possibility of continuing sovereign debt issues in Europe.

What about in years to come? We believe that the role of the small investor, like the market itself, will ebb and flow. The small investor will be back and the market will benefit as a result.

Brenda P. Wenning of Newton is president of Wenning Investments LLC of Newton. She can be reached at Brenda@WenningInvestments.com or 617-965-0680. For additional information, visit her blog at www.WenningAdvice.com.

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